Mairi MacDonald examines the international 'bread and butter' binder business, and finds a sector that, while 'unglamorous', nevertheless offers a lively stream of profits
Binder business is the bread and butter of the Lloyd's market. This often-ignored class earns its sizeable profits from the scraps of insurance that others won't touch.
In this distinctly unglamorous sector, the saying that "if you look after the pennies, the pounds will take care of themselves" certainly rings true. Incredibly, an income of just under $10bn was brought to the Lloyd's marketplace last year through binder business, so while it may look like dirty work, the benefits are more attractive than one might first think.
Lloyd's syndicates have long delegated underwriting power to coverholders, often brokers or other intermediaries.
The basic principle of the binding-authority mechanism is to allow insurers to tap into a local market for business that is too small for an underwriter to handle, via coverholders with local expertise and the expertise in a specific class of business. The coverholder, or managing general agent (MGA), then earns commission by writing cover under the Lloyd's banner.
Much of Lloyd's binder business stems from the UK motor- and home-insurance markets, and a large chunk from the US surplus-lines market, which are largely commercial property and liability lines that have been rejected by the US admitted market, making them eligible for exportation overseas. It most probably ends up in London, the US' second-largest surplus lines writer after insurance giant AIG.
The coverholder therefore has direct links via a US or London broker to Lloyd's underwriters, which also means indirect access to the Bermudian market.
In a report on the US surplus-lines market published in 2006, ratings agency AM Best found Lloyd's US surplus-lines premium accounted for approximately 49% of total US premium written by Lloyd's in 2005, and 51% of US premium written in that year. The report also predicted that robust earnings would continue despite the softening market.
Binder business is generally less prone to the peaks and troughs of the insurance cycle, and many insurers rely on it for a pretty predictable income.
Lloyd's underwriters, Liberty Syndicate 4472, expect approximately 15% of the business it writes this year to be written under binders, amounting to $262.4m.
Speciality-class underwriter Richard McCarthy says: "Binding authority works for Lloyd's syndicates because it helps us attract the kind of business we've been involved with for over a hundred years, which tends to be the risks the US-licensed companies don't want."
US binder business at Lloyd's is characterised by long-standing relationships between its underwriters and brokers and their US partners. "Nearly all my relationships with coverholders go back 20 years or more," explains Mr McCarthy.
"That's very advantageous from our perspective, as it's a real long-term relationship and is person to person. They make a relatively small amount of commission on the premium, so where they can enhance the profit for their corporation is in profit-sharing with the insurer, which is agreed within the annual contract."
Binder business makes up about 20% of Catlin's group business, or more than $500m in gross written premiums.
Gary Mountford, a senior class underwriter who leads Catlin's binding authority cost centre, where some 90% of business comes from the US, says: "We rely on long-term relationships, which sounds like a cliche, but in binding-authority accounts, a lot of our coverholders have been with us prior to us even being at Catlin. Historically, we can trace relationships back 30 years."
The flip side is that the sector's reputation has been sullied for this very reason; past high-profile cases have proven that agreeing a deal on little more than a handshake is not best practice.
Checks and balances
One of the biggest cases occurred during the 1970s when Lloyd's syndicate Sasse was put out of business due to badly managed binding-authority insurance written by US-based coverholder Den-Har.
While a third of Lloyd's income is generated from binding authorities, stringent checks and balances have been implemented in recent years to protect the market against sham broking and irresponsible underwriting.
Today, says Mr Mountford, one of the most important safeguards against coverholders writing too much poor-quality cover is to share the profits. He says: "The biggest single dilemma is obviously that underwriters are remunerated on profit, whereas the broker and the coverholders are remunerated on commission income - the more they write, the more they earn.
"Probably the simplest solution is a profit commission so the coverholders share in the profitability of the account. Because we have formed long-term relationships, our coverholders have continued to get a consistent message that we never change the goalposts.
"If the coverholder achieves that level of expected profit over time, they can bank on having the cover in place in the medium to long term, and that keeps them fairly focused. When the market hardens, our product really becomes a greater asset for coverholders because typically the bottom percentage, in the event of a sudden hardening, will be non-renewed, so that's quite an incentive for profitability."
The regulatory clean-up and increased electronic sophistication, which has improved levels of control in binder business, is making this once-tarnished market more appealing to the broader insurance market. Brokers and underwriters who have shored up their own company controls have broadly welcomed the additional red tape.
Just because a US broker has been authorised by Lloyd's, it doesn't necessarily mean a prospective coverholder would meet the syndicate's own criteria. Brokers and underwriters will also check the finances and reputation of coverholders, and are expected to pay them regular visits, along with third-party auditors.
Parameters are fixed by the underwriter and the agent, which normally include the maximum sums insured; a list of exclusions excluding classes of businesses; sometimes a set of minimum rates; and excesses, all of which are monitored for the duration of the binding-authority contract, says Mr McCarthy.
Gary Clark, a director at London broker Miller Insurance, says his company also checks whether the MGAs are members of the major trade associations, including the American Association of Managing General Agents (AAMGA) and National Association of Professional Surplus Lines offices (NAPSLO).
According to AAMGA director Bernd Heinze, its membership, which includes 297 managing agents, writes $22.9bn in direct written premiums, of which $2.7bn goes through the London Market. While the membership numbers for some such trade bodies have fallen, this is thought to be due to greater consolidation in the marketplace.
Mr Clark says: "There were a number of overseas and UK coverholders that did not get their licence or approval when the market went down this route of tightening up controls. Market controls are the best I've seen in 25 years."
Mr McCarthy agrees that the attention being paid by the market - including the companies, Lloyd's, the regulators and US trade organisations - to making the binding system more secure has paid off: "Going back to the 1970s and 1980s, before claims management became more sophisticated and there was good actuarial input, there were some American legal-liability factors that gave the market problems, but we're much more aware of the issues now.
"With two of the brokers I do business with, I can look at every single risk they have bound through the Lloyd's brokers extranet and find details of every single risk the coverholder has written in real time. It's a very important underwriting tool.
"We also rely heavily on the brokers who will regularly visit those coverholders abroad and not just play golf, but check that they are doing a good job."
Technological advances are improving efficiency and tightening up the monitoring of coverholders' underwriting activity.
Mr Mountford says: "Things are getting far more technical than ever before. We're using catastrophe modelling far more as is the industry in general. We're taking advantage of technology so we can actually view risk in real time as opposed to getting a batch of certificates in the post. We have greater actuarial capabilities along with most of our peers. The compliance side of the industry in general has improved significantly, so we are now looking at coverholders in far greater detail than we ever did before."
Mr Clark explains that data is processed into the market via the internet and 'translated' using the ACORD data standard that has been widely adopted. He says: "The market has gradually improved its ability to capture and analyse data, and there is a much greater understanding of the exposures in any given area. There has been a big drive from the market for both capacity providers - Lloyd's as a franchise and the regulator - to be able to demonstrate that if you are delegating your capacity, you're monitoring the exposures you've accumulated over a period of time. That is crucial to the successful running of a binding-authority book."
No system is foolproof, yet most market players are confident the system is sufficiently robust to protect against rogue parties now.
Mr McCarthy adds: "You're looking at actuaries helping you plan the business and make sure the ultimate profitability is always there; you're working with the Lloyd's regulatory and international department to make sure coverholders are complying with local regulation. The pitfalls are unlikely to be expensive or spectacularly bad news.
"We need to make sure there is no skullduggery and no surprises," says Mr McCarthy.
There is much to be upbeat about in the binder sector, although how much the changes in the insurance legislation in Florida and extension of the state catastrophe fund will affect the property insurance business is yet to be realised. The sector probably has less to fear since it ordinarily functions on an even keel compared to other parts of the insurance industry, and only took a minor hit from Hurricane Katrina compared to the reinsurance and US direct insurance markets.
Mr Mountford says: "If you were writing business in the area affected by Katrina, you would have undoubtedly got some loss from the aggregate exposed in the affected area as we did, but on top of the prior years of hurricanes, Katrina has caused a hardening of the market in catastrophe-exposed areas.
"The interesting thing is, it looks like it is causing a softening of the market in non-catastrophe areas as people pull away from catastrophe exposure and chase non-catastrophe, so we find ourselves in two market cycles at the same time, which is unprecedented in my career."
The future looks rosy for binder business, with forecasts suggesting further consolidation in the market and, in time, fewer MGAs writing larger books into London.
Deeper forays into flood cover in the US are expected, with Liberty Syndicates increasing its coverage, egged on by heightened interest and awareness of possible perils among policyholders. As the insurance cycle softens, binder specialists are expecting increased competition as the wider market follows less-volatile lines of business.
Miller broker Mr Clark is upbeat: "There is evidence that there is pressure on pricing, but as an overall book, the underwriting margins have been very good. The good thing about binder business is that, yes it is price-sensitive, but not as much as the larger risks."
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